By Steven Hay, investment manager fixed interest at Scottish Widows The last quarter of 2001 saw...
By Steven Hay, investment manager fixed interest at Scottish Widows
The last quarter of 2001 saw enormous volatility in overseas bond markets. While there is always increased uncertainty surrounding bond yields around turning points in the economy, the volatility of recent moves in the US 10-year yield, for example, has risen to levels seen only once since 1988.
To illustrate, 10-year US yields fell from 5% in early September to 4.2% on 7 November before rising back to 5.15% in January.
We have been expecting US growth in 2002 to be stronger than consensus estimates, although we note the consensus growth forecast is beginning to edge up. The market is coming round to the view that the US is approaching the bottom of the economic cycle.
Indicators such as non-oil commodity prices, shipping rates and the prices of DRAM chips have all picked up, consistent with revival of global demand. Coupled with progress on the war in Afghanistan, this has led to a reassessment of where bond yields should be.
However, the back-up in bond yields appears to have been exacerbated by leveraged investors being caught long of the market and forced to sell.
Because we are potentially so close to the trough in US GDP growth, it is tempting to look at how yields moved during the previous recession. In late 1992, Fed Funds troughed and yields backed up significantly as the market thought the low in yields had been reached and began to price in an aggressive upward profile for rates.
This reaction turned out to be premature. Short yields fell back to their previous lows and the yield curve between two-year and 30-year bonds flattened 250 basis points over the following two years.
The global deflationary trend is likely to remain intact throughout 2002. Inflation in both the US and Europe is expected to fall to 1% towards the middle of the year.
Some evidence of a slight pick-up in commodity prices has appeared but there is so much spare capacity in product and labour markets globally that inflation expectations are unlikely to rise for some time.
Moreover, the recent deterioration in government budget balances has generally been from a position of budget strength.
Even after substantial fiscal easing in the US, and to a lesser extent in Europe, the size of global fiscal deficits is unlikely to have a significant effect on bond yields. The announcement that there would be no more US 30-year issuance and that a number of European debt agencies intend to shorten the maturity of their debt has also been a positive for long yields.
With ageing populations, there is also a move to increase private pension savings in Europe to augment the pay-as-you-go systems employed in many countries. This will create additional demand for bonds and, in particular, long-dated bonds. Long ends of the yield curve should remain well bid.
While there is substantial uncertainty about the exact growth profile in 2002 and the consequent path of short rates, we believe there are a number of positive fundamental factors that should support long bond yields over the next 12 months. Yields are likely to be higher in 12 months time but a portfolio that is positioned overweight in long bonds should outperform.
Lack of inflationary pressure.
Budget deficits contained.
Growth of private pensions.
‘Important to have an anchor’
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